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Keeping Company Sale Proceeds: Indemnification-Related Provisions

The indemnification-related provisions are the most important outside of the purchase price itself in a company sale transaction. This post outlines indemnification-related issues when negotiating a company sale.

In the vast majority of sales of privately held emerging companies, the indemnification-related provisions are the most important outside of the purchase price itself—these provisions often determine whether the seller may hold on to the amount paid by the buyer.  I say “indemnification-related” as it is typically not the indemnification provisions themselves that are most important.  Rather, it is the provisions that define and limit the rights to indemnification, determine how damages are calculated, and state when the rights can be exercised.

For example, the upper limit of the amount of indemnification damages that a seller is responsible for in the event that there is an indemnification claim (commonly referred to as the “cap”), is often more important to the seller than the indemnification language itself, which can be written fairly broadly.

While the indemnification-related provisions are important, they are relatively complex and interrelated.  A negotiating “win” in one area for a seller, such as a low cap on the amount of indemnification damages available to a purchaser, can be negated by a negotiating “loss” in another area, such as broad exclusions from the cap.  Because of how these provisions are interrelated, we usually review and negotiate them in their entirety.

Here is an outline of indemnification-related issues that are often negotiated in a company-sale transaction:

  • Survival of representations and duration to make indemnification claims
    • Duration of survival of “fundamental” representations
    • Duration of survival of other representations
    • Time period to make indemnification claims
    • Exclusions from any of the above
  • Sandbagging
    • Anti-sandbagging provisions
    • Pro-sandbagging provisions
    • Silent
    • Nonreliance provisions
  • Indemnification as the exclusive remedy
    • Covering all transaction-related documents
    • Exceptions to the exclusive remedy
  • Cap
    • Amount
    • Exclusions
  • Basket
    • Amount
    • Exclusions
    • Deductible or first dollar
  • Materiality Scrape
    • None
    • Single
      • Breach
      • Damages
    • Double
  • Indemnification damage reduction
    • Tax benefits to buyer
    • Items covered by insurance
    • Buyer obligation to mitigate losses

As indemnification and related provisions are complex and sometimes difficult to understand, they are frequently glossed over by those who do not have the background (or patience) to take the time to understand them.  These provisions, however, can have a significant impact on the financial end result of the sale transaction.  Having a comprehensive negotiating strategy when negotiating indemnification-related provisions is often crucial to a successful sale transaction.

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A Company Sale NDA is Different

A common misperception is that all Confidential Disclosure and Nondisclosure Agreements (NDAs) are virtually the same. This article describes some ways that company sale NDAs can be different.

A common misperception is that all Confidential Disclosure and Nondisclosure Agreements (NDAs) are virtually the same. In other words, many people think that it doesn’t matter whether an NDA is for a vendor, customer, employee, strategic, or potential sale transaction—a standard NDA should be sufficient. The truth is, they are and should be different. This is especially true in the company sale context.
Here are some ways that company sale NDAs can be different:

(1) Definition of confidential information

The description of what constitutes confidential information in typical NDAs does not include a number of things that a seller often wants kept confidential in the sale context—most notably, the fact that the seller is considering selling the business or that the buyer and the seller are interested in a sale transaction.

(2) Permitted use of confidential information

A general use restriction seen in “standard” NDAs is often insufficient as a limitation on use of confidential information shared in the company sale context. Moreover, if the buyer is in private equity or is another type of financial sponsor, a limitation on using the confidential information only in connection with the consideration of a potential acquisition of the seller may not be adequate. It often does not limit the disclosure of confidential information to other potential buyers as part of a “clubbing” deal, which sometimes is counter to the seller’s desire to create competition among suitors.

(3) Who the buyer can share the information with

Many NDAs typically restrict disclosure of information by the recipient to those within the recipient’s organization who “need to know” for the stated purpose. Often, in the company sale context, buyers need to also share that information with financing sources, investment bankers, transaction consultants, lawyers, and others.

(4) Non-solicitation of seller’s employees and customers

While it is uncommon to see restrictions on solicitation of a party’s employees and customers in the typical NDA, it is more common to see the matter covered in a company sale NDA as those relationships are more vulnerable in the sale context, especially if the employees and customers know that the seller is interested in selling.

(5) Antitrust requirements

If the buyer is a competitor, provisions and processes should be included that address antitrust concerns.

(6) Seller point person

It is somewhat common to see an individual within the seller’s organization designated as a point person for whom the buyer must work through to obtain confidential information. The intentional procedural bottleneck is designed to ensure that relevant people within the seller’s organization are appropriately briefed, that certain people within the seller’s organization are not contacted by the buyer, and to some extent, keep track of the confidential information that is disclosed.

(7) Seller’s form of NDA

A common issue in many commercial transactions is whose form NDA should be used. In the company sale context, however, use of the seller’s form of NDA is the norm. Also, it is more common to see the NDA in the form of a letter, countersigned by the potential buyer, rather than the standard form of two-party agreement.

Because of some of the unique issues that arise in company sale transactions, sellers should craft the form of NDA they use with those unique issues in mind and not rely on forms or templates used in other contexts.

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Letter of Intent Deal Terms for a Company Sale

In most deals, a seller in a company sale process has the most leverage at the LOI stage of negotiations. It’s typically a good idea for a seller to get tentative agreement at the LOI stage on key terms that inevitably have to be negotiated. This article summarizes some of the common key terms to include in an LOI.

Following the nondisclosure agreement, the letter of intent (LOI) is typically the first step in formalizing the company sale process when a company auction process is not involved.  The LOI stage is usually an exciting time for the seller—the seller is full of optimism, there is no deal fatigue, and the new relationship with the buyer has not yet been tested by heated discussions.

The LOI can accomplish a lot.  At a fundamental level, it establishes whether there really is a deal on key issues.  Often times, first time entrepreneurs and those who have not been through a company sale process are willing to proceed with a lengthy “no shop” or “no talk” exclusivity requirement, based only on a non-binding agreement on price.  While purchase price is obviously an important term, it by no means is the only important term.

In most deals, a seller in a company sale process has the most leverage at the LOI stage of negotiations.  The seller has not invested a lot in the deal and it’s the easiest point at which to just say “no” to a request of a buyer.  Rarely, however, do terms get better for the seller after the LOI stage.  On the flip side, buyers will typically take aggressive positions after the diligence process or on the initial draft of the purchase agreement.  They know sellers have committed a lot to the deal and at some point in the process, become committed to making the deal happen for a variety of reasons.  Often, a seller is willing to concede more at a later stage than what the seller would have been willing to do earlier.  As a result, it’s typically a good idea for a seller to get tentative agreement at the LOI stage on key terms that inevitably have to be negotiated.

From a seller’s perspective, here are some of the areas worthy of consideration of including in the LOI:

  • Deal structure, especially if the seller is looking for capital gains treatment
  • Items that affect net proceeds at closing
    • Escrow holdback amount and time period for the escrow, or a statement that there will be no escrow
    • Working capital adjustment amount or a statement that there will be none
    • Earn-out (if any) or a statement that the listed purchase price does not include one
  • Duration of the survival period of seller’s representations and warranties
  • Basket and cap for post-closing liabilities
  • Indemnification cap exclusions
  • Employment requirements of key individuals or at least which individuals or types of individuals the buyer intends to retain, post deal (e.g., 80% of software engineers)
  • Targeted closing date

Buyers will often resist some of the provisions under the guise that, “we don’t know enough information at this point, so we prefer to agree upon those terms after the diligence process.”  The same thing though could be said of the purchase price.  The reason to negotiate the points earlier is that it places the burden on the buyer to change them later.  Once a term is in the LOI, the parties usually tend to feel sort of a “moral” obligation to adhere to those terms.  Buyers frequently need a major diligence finding to justify a modification to a term contained in the LOI, even though those terms are usually nonbinding.

Including more deal points in the LOI also helps to limit surprises later that may surface, such as, “we always require sellers to have no indemnification cap for breaches of representations related to intellectual property.”  Moreover, without touching on the key deal points at an early stage, it’s hard to determine whether the parties have a basic meeting of the minds, even with the assumption that there will be no material surprises in the diligence process.

As with most other things, deciding on the appropriate amount of detail in the LOI is a balance.  On the one hand, it requires including enough detail to help ensure that there really is likely a deal, while also, from the seller’s perspective, taking advantage of the leverage that a seller typically has at the LOI stage.  On the other hand, the seller should not put too much pressure on the buyer at the formative stages in adding too much detail and unnecessarily elongating the time period of the LOI stage.  Striking the right balance is the first step in a successful sale process.

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The Confusing World of Joint Ownership of Intellectual Property

A confusing topic for many emerging companies is joint ownership of intellectual property. Many of the implications of jointly owned intellectual property are counterintuitive. In this post, we breakdown the implications of joint ownership by the default rules in the United States for patents, copyright, trade secrets, and trademarks.

A confusing topic for many entrepreneurs is joint ownership of intellectual property.  It often comes up in connection with joint development arrangements, subcontracting portions of work, joint ventures, and other collaborative projects involving intellectual property development, whether it be in connection with software, cleantech, medical device, drug development, or other technology-based initiatives. Continue reading →

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Who Owns the Rights to Customer Feedback?

An issue in many software licenses and SaaS service agreements relates to who owns or has rights to use customer feedback related to the software or SaaS offering. This post addresses the intellectual property issues related customer feedback and the approaches many companies take to customer feedback.

Suppose a customer proposes an idea to improve the software or SaaS offering of a company. The company likes the idea so much that it integrates the idea into its next upgrade. The question becomes, who owns the idea that is integrated into the software or SaaS offering?

As a general rule, the person who creates an idea, authored work, invention, or process, owns the related intellectual property.  There are exceptions to the general rule.  But, in the software and SaaS arena involving licensors and licensees, the general rule applies in most circumstances. Continue reading →

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Bridge Financing Documents

One of the sets of documents that we have automated at AlphaTech Counsel is the bridge financing documents for an emerging company. Attached is a sample of the documents.

One of the sets of documents that we automated at AlphaTech is the bridge financing documents for an emerging company.  Attached is a sample of the documents: Convertible Note and Subscription Agreement

Instead of just using form documents as most law firms do, robust automation allows us to deliver common document sets for emerging companies in a more efficient manner.  So what else does “robust automation” yield?  It improves document accuracy, provides a valuable knowledgebase from which to draw, and enables us to deliver common document sets to our clients quickly.  It also frees up time of our lawyers to enable them to spend less time on basic contract drafting and more time on activities that afford our clients higher value. Continue reading →

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LLC Choice of Entity for Emerging Technology Companies

The recent $1 Billion Qualifying Therapeutic Discovery Project Credit program should be a real boon to many area companies. A surprise to many though when reading the fine print of the program is that limited liability companies that have a tax-exempt organization as an owner, as many university biotech spinoffs do, are not eligible for a grant under the program. While there is a cumbersome fix for this, the “LLC issue” for emerging companies extends well beyond this grant program, however.

The recent $1 Billion Qualifying Therapeutic Discovery Project Credit program will be a real benefit to many area small life science and medical device companies. A surprise to many though when reading the requirements of the program is that limited liability companies (LLCs) that have as an owner a tax-exempt organization are not eligible for a grant under the program. Having a tax-exempt organization as an owner is more common than one might think. Many university technology transfer offices, such as the Wisconsin Alumni Research Foundation (WARF), are tax-exempt organizations and frequently hold an equity interest in the startups to which they license patents. As a result, those LLC biotech licensees are not eligible for a grant under the program. As the CEO of an LLC with which I work (but did not set up) said earlier this week about being excluded from eligibility, “Ouch! That stings! Another painful learning experience.”

LLCs are Typically Not the Best Choice of Entity for Emerging Technology Companies

The “LLC issue” for emerging companies extends well beyond this grant issue for therapeutic companies. I say this even though many attorneys recommend LLCs for virtually all contexts. Sure, LLCs have their place. I frequently advocate using them as holding companies, investment vehicles, and joint venture entities. Among other situations, it also can be appropriate to use them when there is a limited, small group of owners actively participating in the business or when the owners want to have a certain allocation of profits and losses that cannot be accomplished when using an S or C corporation. But for many emerging companies that have or plan to have outside investors, the LLC is often not the best choice of entity. Continue reading →